How Banks Create Money And Why Governments Should Too: Part 4

Written by Derryl Hermanutz

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Debt-Based Money

Commercial banks do not lend out money they already have and do not lend out their depositors' account balances. Every bank loan and bond purchase is "funded" by the bank's creation of brand new money - a new bank deposit: a new spendable bank deposit account balance. That's where the deposit account money supply "comes from" - it is created by commercial banks.

credit.money.sign

From Modern Money Mechanics: A Workbook on Bank Reserves and Deposit Expansion, Federal Reserve Bank of Chicago (first published 1961; last updated 1994):

"The purpose of this booklet is to describe the basic process of money creation in a "fractional reserve" banking system. The approach taken illustrates the changes in bank balance sheets that occur when deposits in banks change as a result of monetary actions by the Federal Reserve System -- the central bank of the United States. ...

What is money? If money is viewed simply as a tool used to facilitate transactions, only those media that are readily accepted in exchange for goods, services and other assets need to be considered transactions money."

From Economics of the Canadian Financial System: Theory, Policy & Institutions by Shearer, Chant, Bond, Third Edition (1995); from a section titled, Banks and Deposit Creation, p. 565; emphasis in original:

"...the liabilities of banks and other depository institutions have the peculiar characteristic that they are money. When these intermediaries purchase earning assets such as bank loans and promissory notes, they pay for them by issuing their own liabilities. There is no question of the public's accepting the liabilities of depository institutions... The public accepts them because they are accepted as money by others.

Thus, by increasing their earning assets, these institutions at the same time add to the supply of money. The creation of deposits by depository institutions to make loans or acquire securities represents in each case the creation of new deposits. We are now in a position to express our first fundamental principle of deposit creation by depository institutions.

Through the creation of a deposit by making a loan or acquiring a security, a depository institution increases the money supply by the amount of the created deposit."

Commercial banks create new bank deposits when banks make loans to private-sector borrowers; and when banks purchase securities from government borrowers.

"Securities" are interest-bearing Treasury securities: government-issued bills, notes, and bonds; which are interest-bearing repayable government bond debts. Governments issue bond debts to borrow money that is created by commercial banks.

"Bank loans" and "promissory notes" are interest-bearing private sector debts. People and businesses issue loan account debts to borrow money that is created by commercial banks.

"Through the creation of a deposit by making a loan or acquiring a security, a depository institution increases the money supply by the amount of the created deposit."

Private sector debtors issue interest-bearing loan account debts: mortgage loan debts, student loan debts, car loan debts, credit card debts, home equity loan debts, small business loan debts, corporate loan debts, institutional loan debts, etc, etc.

Government debtors issue interest-bearing Treasury bills, notes, bonds: government bond debts.

And commercial banks issue their own debts - deposit liability debts: bank deposits - to "pay for" the banks' purchases of those new interest-earning debt assets.

Banks use debtors' interest-bearing debts as the banks' interest-earning assets.

We use commercial banks' deposit liability debts as our deposit account money supply.

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